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Sunday, 5 September 2010

Caught Between Extremes

The Malta Independent on Sunday - 05 09 2010

I just finished reading a Research Note issued by a major global bank on ‘The Future of the Euro’ and it is clear that as the Euro area gets ever more divided into two extremes, Malta is sitting right in the middle. It is not a bad place to be.
If all other Euro members were sitting in close proximity the monetary union would be a much happier and peaceful place.

Reality is much different.

Essentially the EU has become divided into three groups giving a de facto three speed EU.

Motoring along at awesome speed, practically as if the global crisis never happened, are Germany Austria. Netherlands and Scandinavia ( Denmark, Sweden and Finland) who along with Luxembourg and Switzerland are by all measures out of the recession, seeing unemployment falling, growth returning at pre-crisis rates or better, improving fiscal structures and strong balance of payments position.

At the other extreme you have Ireland, Portugal, Spain and UK who are undergoing strong fiscal consolidation to address chronic fiscal imbalances, at a time of high unemployment and economic contraction while dealing with a broken banking system severely damaged by the bursting of the property bubble.

Greece has not been included in the extreme group at the wrong end of the spectrum because even within this group Greece would be an outlier.

Greece’s problems are not so much caused by the global crisis but by a long period of economic mismanagement, undue rigidities suppressing the spirit of innovation and competitiveness, and fiscal evasion on massive scale in an engrained culture of public sector corruption and social benefits fraud.

In the middle close to the point of general equilibrium are a group of countries led by France and Italy comprising Belgium, Slovakia, Slovenia, Cyprus and Malta.

This middle group shows general equilibrium with respectable balance of payments position, slow but positive growth, a healthy banking system underpinned by strong domestic thrift culture, and a fiscal position which although outside the normal Maastricht criteria remains acceptable in the context of a global recession and is expected to continue improving through a combination of increased fiscal revenues from normal growth and mild austerity measures. Where do we go from here?

Two reflections first.

For all self-criticism about our state of things when examined from the outside looking in, we are quite in shape. Of course we should be much better given that we are nursing a substantial accumulation of national debt over the last quarter century which is not reflected in the state and quality of our infrastructure.

But as a nation, rather than as a government, we have been prudent and hardworking, we have avoided leverage exposure to foreign lenders and we have kept this a fairly good place to live or visit, with a quality of life superior to what pure financial per capita income would tend to suggest.

With careful and well planned investment, avoiding the sort of tragicomedies we are experiencing in the Delimara power station extension contract, we can make this a much better place and can render our economy more competitive and stable.

Secondly we are living in times of extremes.

Half of the economic cadre, the likes of Paul Krugman in the US and Martin Wolf in UK, argue that governments need to continue stimulating the economy to create demand as otherwise the contraction in consumption could lead the economies of US and UK into a dangerous depression which it would be very painful to recover from.

At the other extreme we have the Chicago economic school of thought who firmly believe in the self healing powers of the free market, arguing that the last stimulus was a perfect waste of money and that further stimulus would be more so as the market needs to be given time to self correct and governments should as much as possible get out of the way by reducing taxes, rather than take a more central role in managing demand.

For those mindful of economic history it is the Keynesian school in a tussle with Ricardian School, but this time in extreme doses.

Experience shows that reality is somewhere in the middle.

I believe that the crisis of 2008 was so sudden and sharp that without massive government intervention we would have experienced a thirties style depression. Now that the economy has been stabilised, even though growth is anaemic and well below potential, further benefits from any stimulus would be outweighed by the negative vibrations from increasing fiscal deficits.

With governments having limited economic and political capacity to increase deficits to stimulate demand, and with monetary policy having exhausted most of its tool box and at best capable of avoiding a depression but is as likely to stimulate demand as ‘pushing on a string’, growth will be organic, slow but sustainable.

In this context a major portion of the stress of the adjustment process will have to be carried by the foreign exchange markets. Countries with chronic Balance of Payments surpluses will see pressure on their currency to appreciate.

We are witnessing the Japanese Yen and the Swiss Franc reaching record levels and the China facing increasing political pressure to let its currency float a bit more freely to reflect the country’s economic progress.

Countries with deficits will be forced to see their currencies depreciate as the only practical way to balance their economies by gaining competitiveness on the export front and fill their resource gap through foreign demand as home consumers stay on the lean and meant while deleveraging and repairing their balance sheets.

Central among these is the US which desperately needs a weaker dollar.

In this context the Euro is an enigma. The German core are having a free ride through being super competitive without finding appreciating pressure on their currency which is kept down by the woes of Greece and its companions in distress.

The problems of Greece, Ireland, Spain and Portugal are a big bonus for German competitiveness.
Unfortunately labour mobility within the EU is still very viscous. Were it otherwise the Greeks and the Spanish would merely pack their bags and move to fill opportunities in German core countries.

This will not happen on any significant scale.

These imbalance and the pressure they build in a monetary union among members with very disparate economic realities will continue to stimulate tensions putting the future of the euroin jeopardy. A small country like us has no choice but to watch out with vigilance while building a strong balanced economy to protect us in the turmoil that awaits.